Facts about mutual funds that may surprise you

George Sisti, CFP, is a certified financial planner practitioner and the
founder of On Course Financial Planning, a fee-only Registered Investment
Advisor firm. George graduated with a BS in Mathematics from the State
University of New York at Stony Brook in 1971. After graduation, he served 6
years as a pilot in the United States Air Force, based at McChord AFB, WA. In
2013 he retired after a 35-year career as a pilot for a legacy U.S. airline. George established On Course
Financial Planning in 2004 to help families gain the peace of mind that comes
from knowing that they will be able to retire at the time of their choosing and
not have to worry about running out of money in retirement. He has been a member
of the Financial Planning Association since 2004. He can be contacted through
his website: oncoursefp.com

The disclaimer "past performance is no guarantee of future returns" appears in mutual fund ads to warn investors that the advertised performance is unlikely to continue.

Standard & Poor's semiannual S&P Persistence Scorecard tracks the subsequent performance of top performing mutual funds. The June 2014 scorecard analyzed the 853 actively managed domestic stock funds with top-half performance for the five years ending in March, 2009. How many of these funds retained top-half status for the next five years?

By random chance alone, 50% (426) should have remained top half performers. Yet only 37% (317) managed to do so.

The Persistence Scorecard also tracked funds with top 25% performance (called top-quartile funds) for the five years ending in March, 2009. Perhaps the 427 funds that generated this level of peer outperformance employ talented fund managers. By random chance alone, 25% (107) should have remained top-quartile performers for the ensuing five years. Yet only 14% (59) were able to do so. S&P concluded:

”An inverse relationship exists between the measurement time horizon and the ability of top performing funds to maintain their status ... The figures paint a poor picture of a lack of long-term persistence in mutual fund returns.”

If the number of repeat top performers is less than what we expect from random chance, why should we give the credit to manager skill rather than luck? The Persistence Scorecard provides a periodic reminder of how difficult it is for top performing managers to repeat their success in subsequent years.

It might be imprudent for the manager of a narrowly focused fund to invest a large portion of his wealth in a non-diversified manner. So let’s lower the bar (something we often do when dealing with active managers) and ask, “What percentage of mutual fund managers don’t invest in the fund that they manage?” An article in Barron’s reported that the answer is — almost 50%. Why do so many fund managers refuse to eat their own cooking? I’d love to know what percentage of active fund managers have more money in index funds than in their own fund.

An article in the July/August issue of the Financial Analysts Journal might help us discover why so few managers invest in their own fund. The authors studied the performance and manager tenure of 2,846 single manager stock mutual funds from 1996 through 2005.

The article begins:

” The literature suggests that a very small subset of managers may possess skills that enable them to consistently outperform the market or their peers, but most managers don’t possess such skills. How does the labor market function given that the majority of managers don’t possess particular skill at their jobs?”

In other words, how do employers deal with employees who, as a group, possess no skill for the task they were hired to accomplish? Not surprisingly, they fire them. Of the 2,846 funds studied, only 195 (6.9%) had the same manager by year-end 2005. More than half of all fund managers were fired within the first three years and more than three quarters were fired within the first five years.

Let’s consider the plight of an employee who invests in four different actively manage stock funds in her 401(k). The article reveals she should expect that three of her funds will have new managers within the next five years — the old ones having been fired for underperformance. Is this any way to accumulate wealth?

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